On the information content of ratings: an analysis of the origin of Moody's stock and bond ratings

John Moody published his first railroad security analysis and ratings manual in April 1909. This study analyzes several current issues by looking back at Moody's original intentions for constructing a ratings system. The study analyzes whether Moody intended his ratings to reflect his private information, or rather, to serve some alternative role, as with monitoring conflicts of interests or realizing informational economies of scale. The study uses an ordinal regression approach to evaluate a set of explanatory variables, constructed from both the manual itself and the panic months of 1907, to test the potential information content of Moody's ratings. At the time of Moody's first rating system, the illiquidity of the US Treasury market forced investors to seek alternative ‘high-quality’ securities. Indeed, Moody rated 38.94 percent of railroad bonds as Aaa, and rated 85.25 percent of railroad bonds as A, Aa or Aaa in his universe of railroad bonds rated. To further test the informational content of Moody's ratings, the study pursues a structural default analysis during the panic year of 1907, which yields results that indicate that the default risk of railroad securities was quite low at the time. These results provide justification for the high overall ratings that Moody assigned to railroad securities, and thus their role as near risk-free securities. Therefore, railroad securities, and Moody's ratings, played a particularly important role in the financial system at the time.